Misclassifying workers has consequences for employers

Enterprising entrepreneurs turn a brainstorm into a business. To run that business successfully, the entrepreneur typically needs workers. So a decision must be made: to hire an employee or independent contractor?

Often, particularly in small businesses, the wrong choice is made based on a simplistic approach. To save expenses, it is tempting to classify the worker as an independent contractor. A business owner who limits her analysis to this approach does so at her own peril.

An employer must contribute funds toward an employee’s Social Security and Medicare, but makes no such contributions for an independent contractor. And, independent contractors are not entitled benefits such as health insurance, retirement contributions and vacation. But both state and federal laws apply to misclassification of employees.

The law presumes a person who provides work is an employee, and the employer has the burden of proof to establish otherwise. A written contract is critical in determining the correct status. Nevertheless, a contract classifying a worker as an independent contractor is not dispositive if the worker is actually an employee. Under the Colorado Independent Contractor law, the worker must actually and customarily perform the same service for others and the employer can have no control over how the person performs the work. Alternatively, a written contract will establish an independent contractor relationship if it provides all of these provisions:

The worker is free to work for others.

The employer cannot oversee the work or instruct the worker.

Payment is a fixed rate rather than an hourly or salaried rate.

Termination may only be for breaking contract terms.

The employer provides only minimal training.

The worker provides his or her own tools (although materials and equipment may be supplied).

Time when the work is to be done is not specified (except a schedule of completion or range of acceptable work hours).

Payment is made to a business rather than an individual.

The worker has a separate and distinct business.

Under Colorado law, employers who improperly classify an employee as an independent contractor may be liable for unpaid state taxes, overtime pay, unemployment and workers’ compensation benefits, penalties, interest and attorney’s fees.

The Colorado Independent Contractor law, which became effective June 2, 2009, requires the Colorado Department of Labor and Employment Unemployment Insurance Program to accept complaints and conduct investigations regarding alleged misclassification of employees as independent contractors. If an investigation finds an employer has misclassified employees, the employer must pay all back unemployment premiums owed with interest.

Moreover, if the investigation finds the employees have been misclassified with willful disregard of the law, the employer may be fined up to $5,000 per misclassified employee for the first misclassification, and up to $25,000 per misclassified employee for a second or subsequent misclassification. Additionally, if the employer makes a second or more misclassifications, the employer is prohibited from contracting with, or receiving any funds from, the state of Colorado for up to two years.

The CDLE estimated that from June 2009, when the law became effective, to December 2010, 14.2 percent of Colorado workers were misclassified resulting in $744,359 being underpaid in unemployment premiums and interest during that time frame. It estimated that worker misclassification results in $167 million lost income tax revenue annually. Not surprisingly, the state is increasing enforcement to try to recapture this perceived revenue loss.

But wait, there’s more. The IRS and the United States Department of Labor have different (albeit similar) lists to assess whether a worker is an employee or independent contractor. Under those analyses, in addition to the potential consequences listed above, misclassification of an employee may result in additional employer liability for the value of health-insurance benefits and pension contributions. Class action lawsuits may result to recover these benefits.

Such was the case in Vizcaino vs. Microsoft Corporation, where the computer giant settled with “contractors” for nearly $97 million in unpaid benefits. It was later ordered to pay more than $27 million in attorneys’ fees.

While we don’t have many mega corporations the size of Microsoft in this area, suffice it to say, damages, penalties, interest and attorneys’ fees can be steep.

No business wants to be subjected to an IRS or federal or state labor audit or investigation, much less the significant financial liabilities from an improper classification of an employee.